I recently wrote about the advantages of mutual funds. Today I am going to talk to you about the disadvantages of mutual funds. As with anything in life, there are good things and bad things about mutual funds. It’s important to know and understand the downsides to mutual funds so that you can make the best decision for you and your money. Here are the main disadvantages of mutual funds and what you need to consider before investing in them.
5 Disadvantages Of Mutual Funds
Far and away, the biggest of the disadvantages of mutual funds are the fees. You have all sorts of fees that you can potentially pay – loads, 12b-1 fees, short-term redemption fees, share class fees – the list goes on and on.
For the most part, you should stay away from investing in any mutual fund that charges you any fee aside from the management fee. The management fee is a fee you have to pay, regardless of the mutual fund you are investing in. All of the other fees can be skipped by investing in the right funds.
When it comes to the management fee, you should not pay anything over 1%. In fact, you want to stay under 0.75%. While that fee percentage sounds small, it adds up over time. If you have $10,000 invested in a fund that charges 1% a year, this means you are paying $100 every year just to invest in that fund. As you invest more and your portfolio grows in value, you continue to pay 1% each and every year. Over the course of your investing career, you can easily pay tens of thousands of dollars in fees!
While you can place a buy or a sell for a mutual fund during any time the stock market is open, the trade won’t actually be completed until after the fund’s net asset value is calculated at the end of the trading day.
This can be troublesome for some investors. After all, if the market is in free fall and they want to sell shares at 11am, they cannot do so until after the market closes. They run the risk of the market dropping more during that time, costing them more money. Understand that the same applies when the market is rallying as well. If they want to buy at 1pm, they cannot complete the buy until 4pm, potentially missing out on some gains.
Easy To Over-Diversify
Many investors forget that when they are investing in a mutual fund, the fund owns thousands of underlying securities. The investor only sees their one mutual fund and mistakenly thinks that they need to be more diversified. They go out and buy another mutual fund to feel better. The problem is that this new mutual fund holds the same underlying securities, just in a different allocation.
While they thought they were diversifying themselves, they weren’t at all. Know that you are diversified with just one mutual fund. In fact, you can get away with just 3 mutual funds and be fully diversified.
Lack Of Gain Recognition Control
When you sell a stock, you control when you pay capital gains. But with mutual funds, you could potentially pay capital gains even if you don’t sell any shares. How is this possible?
Remember that many other investors are buying and selling shares of the same mutual fund you own. As a result of this buying and selling, the mutual fund has to buy and sell the underlying securities, usually on a daily basis. Since there is no way the mutual fund is selling the underlying securities for the same price they bought them for, there is a great chance that the fund will incur capital gains, both short-term and long-term. They will then pass these gains onto you, the shareholder.
Because of this, you may have to pay tax on gains even though you never sold any of your shares. This might concern some readers but note two things:
- First, most mutual fund managers are well aware of this phenomenon and do a great job at buying and selling certain tax lots so that they keep capital gains as small as possible. But even still, they do happen
- Second, before investing in a mutual fund, do your homework on the fund. Understand its turnover ratio. The lower the number, the smaller the chance of you incurring capital gains even without selling shares.
Less Predictable Income
When you invest in stocks, you know how many shares you own and what the dividend rate is. A simply math calculation will tell you what you can expect to receive every quarter. For example, if you buy 100 shares of XYZ company and it pays a $1.00 annual dividend, you know you are going to receive $25 worth of dividends each quarter. But with mutual funds, figuring out your income isn’t so easy. In fact, it is nearly impossible.
Since the fund is constantly buying and selling underlying securities, you never know how many shares you own of a stock at a given time. And even if you do find out, chances are that tomorrow that number will change.
For most investors, this is not an issue as you can use the dividend yield to estimate your income. However, if you rely solely on investment income for your retirement, you might be concerned about this.
There are close to 8,000 mutual funds right now. That is a huge amount of investment choices to choose from! In fact, it could be overwhelming to many investors. You might look at the list of large cap mutual funds, see there are 500 to choose from and end up doing nothing because you have no clue where to start.
To help narrow this list down, be sure to eliminate any mutual fund that charges you a load to invest and any fund that has a management fee over 1%. That should narrow the list down quite a bit for you. Even better, just look into brokers that let you invest in mutual funds for no cost at all.
These are the biggest disadvantages of mutual funds. While they are negatives, they shouldn’t be large enough to make you consider not investing in mutual funds. They are an important option for investing success. If you have any questions regarding mutual funds or investing in general, feel free to reach out to me. I’ll do my best to answer your questions. Be sure to also check out mutual fund basics for a good complete overview of mutual funds.
If you want to learn more about investing, consider reading my eBook, 7 Investing Steps That Will Make You Wealthy. Along with the book, you will get a free report of index mutual funds and ETFs to consider investing in and a free portfolio analysis.